What are home equity loans?

With a home equity loan, you can borrow money and use your house as collateral.

If your home has gained value over the years since you purchased it and you need access to a large amount of money, you may want to consider a home equity loan.

Sometimes referred to as a second mortgage, term loan or equity loan, home equity loans are funds that you borrow with your property as collateral. The value of the loan you obtain is based on many factors, with the initial amount calculated from the difference between your home's equity and its current market value. From there, other variables, such as your income and credit history, are considered to derive the actual loan amount you receive.

However, depending on the lender, there may be cap on how much you can borrow against your home. If, for instance, home values are on the rise, that doesn't necessary mean you can take advantage of price appreciation and get a loan equal to 100 percent of your equity.

Unlike a home equity line of credit, the loan amount is given all at once. Whereas HELOCs are often presented in the form of a credit card, the funds from a home equity loan can be deposited directly into your checking account. They are often called second mortgages because they have repayment terms - typically 15 years - like home loans. Interest rates for repayment are usually fixed. In some cases, payments on interest for these loans are tax deductible.

What are home equity loans used for?
Although these loans are similar to mortgages in some aspects, you're allowed to use the money for anything you want. Often, homeowners turn to home equity loans to make repairs or renovations to their property. Getting the funds as a lump sum allows borrowers to budget and best decide which upgrades fit their finances. These loans are also used by parents who need financing to send their children to college.

Another common use for home equity loans is to pay off other debts, specifically credit cards. The loan serves as way to consolidate multiple debts, and the interest rate tends to be more favorable than the individual rates for each credit account.

Generally, purchases or expenses that require a large amount of money at a single time are well-suited for this loan.

When should you get a home equity loan?
If your home has sizeable equity and you need a large loan, borrowing against your house can be a great way to cash in on how well your property has retained its value over the years. However, you should be certain that you can repay the loan prior to borrowing. If you default on your second mortgage, your loan provider can sell your home to recover the outstanding balance.

If you have a stable job and don't expect many financial changes in the future, you likely don't have much to worry about. Yet, a HELOC may be more suited to your needs if you don't necessarily need a lump-sum payment. Unlike a home equity loan, the amount you're allowed to borrow with a HELOC functions as a credit limit, and you can borrow money against that limit for a designated period of time. When using the credit to pay for something such as renovations, having access to fewer funds over time could be fitting. If, for example, your contractor has you make payments through various stages of the project, you don't necessarily need the total amount at once.

When ultimately deciding on a home equity loan, be sure to read all closing documents to understand your repayment responsibilities.